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A close friend recently asked my opinion about Rackspace Hosting (NYSE:RAX). I did not know much about the company then, but after briefly looking up some financial ratios I quickly dismissed the stock as overly expensive. I further suggested my friend be very careful with the stock.

But it kept me thinking, and knowing what I know about richly valued companies (which is just about enough to know what NOT to do) I gave my friend the benefit of the doubt and decided to take a dive into this company. I read the latest 10K, 10Qs, conference call transcripts and some relevant news to help me understand the company and build a financial model. The more I dug, the more uneasy I became.

From the latest 10-K:

We are a hosting specialist, which means that our entire business model is related to the delivery and support of hosting solutions for our customers. Hosting and cloud computing is best described as IT services delivered on demand over the Internet. Our hosting solutions provide our customers with an infrastructure in which to house their data and customer support for their hosting solutions. Our rapid growth over the last decade has been fueled by our commitment to provide customers with our unique brand of customer service known as Fanatical Support.

There's no doubt that more and more companies nowadays are deciding to host their entire IT infrastructure outside of their organizations. It's also true that the future of the companies that provide these hosting & cloud services look promising because of the ever-growing amount of data that companies generate on a day-to-day basis, the power of the Internet, and the ever-shrinking cost of hardware infrastructure. The bigger and more reliable these companies become, the cheaper the hosting solutions they offer as a result of economies of scale.

So let's review how Rackspace has been performing over the last 5-6 years. Since this company provided no guidance in their Q3 2011 results and have not yet announced their Q4 & FY 2011 numbers, I will assume for Q4 2011 the same revenue growth experienced in Q32011 over Q32010, as well as equivalent margins from the 2011 nine reported months to derive the rest of the 2011 numbers.

2006

2007

2008

2009

2010

2011*

Revenue

224.0

362.0

531.9

629.0

780.6

1,092.3

%Growth y/y

61.4%

61.6%

46.9%

18.2%

24.1%

39.9%

Gross Income

159.1

243.8

359.4

428.1

530.7

759.2

%Margin

71.0%

67.3%

67.6%

68.1%

68.0%

69.5%

Operating Income

31.2

30.6

40.1

55.2

79.6

123.3

%Margin

13.9%

8.5%

7.5%

8.8%

10.2%

11.3%

Effective Tax Rate

35.5%

35.8%

33.6%

35.1%

35.1%

34.3%

NOPAT

20.2

19.7

26.7

35.9

51.7

81.0

%Margin

9.0%

5.4%

5.0%

5.7%

6.6%

7.4%

%Growth y/y

87.4%

-2.5%

35.6%

34.6%

44.1%

56.7%

EPS

0.19

0.17

0.19

0.24

0.35

0.55

%Growth y/y

72.7%

-10.5%

11.8%

26.3%

45.8%

56.8%

Source: Company SEC Filings. Amounts in millions.
*Assumes a revenue growth rate in Q4 2011 of 32.48% over Q3 2011.

Operating Efficiency & Profitability

2006

2007

2008

2009

2010

2011*

NOPAT Margin

9.0%

5.4%

5.0%

5.7%

6.6%

7.4%

Asset Turnover

1.7

1.2

0.8

0.9

1.0

0.8

Leverage

1.9

3.1

2.5

1.9

1.7

1.8

ROE

28.6%

20.3%

9.9%

10.3%

11.8%

10.0%

*Based on Q32011 numbers.

Balance Sheet Selected Items

2006

2007

2008

2009

2010

2011*

Cash & Equivalents

8.4

24.9

238.4

125.4

104.9

124.7

Total Assets

133.0

301.8

685.3

668.7

761.6

970.7

Long-Term Obligations

16.4

96.2

283.1

161.0

133.6

187.3

Stockholders' Equity

70.5

96.9

269.7

349.4

438.9

551.1

*Based on Q32011 numbers. Amounts in millions.

Hosting a market cap of 6.5B, this company has been growing revenues steadily, delivering consistent positive growth in installed base, keeping a tight control in operating expenses, realizing economies of scale, obtaining more customers (as of Q32011 it had a fairly diversified base of 161,422 customers with none of them representing more than 2% of overall revenues, although it's important to note that customers are counted on an account basis, therefore a customer with more than one account would be included as more than one customer), having a small & controlled interest-bearing debt, growing profit margins faster than revenues, and realizing a return on invested capital in the low double-digits, higher than their weighted average cost of capital. Anyone trying to find a black sheep in this happy family of operating numbers would be quick to point out that the profit margins are not too high, as compared to other high-growth outstanding businesses with rich valuations - think Intuitive Surgical (NASDAQ:ISRG) or Chipotle Mexican Grill (NYSE:CMG).

But there's even a bigger and more disturbing black sheep developing in the internals of the company. The company earns its revenues from two types of customers: 1) Managed hosting customers; and 2) Cloud customers. The difference between the two is that revenue from managed customers is earned on a subscription-based business model whereas revenue from cloud customers is earned on a pay-as-you-go business model (utility-based). The former has a much higher gross margin than the latter.

On the latest 10-K, the company stated:

"The advent of virtual and cloud technology services provided on an utility basis are becoming more prevalent. During 2010, our recurring revenue has increased across our portfolio of services, but utility based service revenue has grown at a significantly faster rate than our subscription service revenue. We believe that this trend will continue as the market changes the way it consumes computing resources and more companies begin to utilize cloud solutions."

Just look then at the following trends and draw your own conclusions. In fact, the company stopped providing a breakdown of the types of customers starting in Q1 2011, and I couldn't find a reasonable explanation for it. You can make the informed conclusion that the company is experiencing the first ever negative year-over-year growth in managed hosting customers:

2006

2007

2008

2009

2010

2011*

Total Customers

12,677

29,193

53,300

90,925

130,288

161,422

Managed hosting customers

12,016

15,454

18,480

19,304

19,393

N/A

%Total

94.8%

52.9%

34.7%

21.2%

14.9%

N/A

%Growth Y/Y

**

28.6%

19.6%

4.5%

0.5%

N/A

Cloud customers

661

13,739

34,820

71,621

110,895

N/A

%Total

5.2%

47.1%

65.3%

78.8%

85.1%

N/A

%Growth Y/Y

**

1,979%

153%

106%

55%

N/A

Revenue p/Customer (in 000s)

17.7

12.4

10.0

6.9

6.0

4.6

NOPAT p/Customer (in 000s)

1.59

0.67

0.50

0.39

0.40

0.3

*No breakdown provided starting in Q1 2011.
**No information available for 2005.

In addition, although the company experiences positive "installed based growth" (which is a metric calculated as the difference between "net upgrades" and defection "churn," where net upgrades measure the incremental monthly recurring revenue from customer upgrades less downgrades as a percentage of total monthly recurring revenue before customer credits; Churn measures the reduction of monthly revenue due to customer terminations as a percentage of total monthly recurring revenue before customer credits), it also experiences churn on a consistent basis. If you further read the following extract from the risks section of the 10-K, you can understand why I had started to become a bit uneasy about this company:

Our costs associated with maintaining revenue from existing customers are generally much lower than costs associated with generating revenue from new customers. Therefore, a reduction in revenue from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue to retain our existing customers could have a material adverse effect on our operating results.

Although management operates this company quite efficiently, some of the fundamentals have begun to deteriorate. In terms of valuation, RAX is currently trading at 61.3x Forward P/E, with earnings per share expected to grow 52.83% in the next year (and 30.35% annualized for the next 5 years). It has been making new 52-week highs as a result of the recent market surge and the expectations in the upcoming earnings release . Other ratios include P/B of 11.81x, P/S of 6.8x, and P/FCF of 103.8. Inherently you are paying $61.3 for every $1 of earnings. In other words, you are getting a yield of 1.63%, just enough to take you 61 years to recoup your investment.

To add insult to injury, there was a rumor (unconfirmed) circulating today that Amazon (NASDAQ:AMZN) is soon cutting Data Storage Costs, which would be very negative for Rackspace because Amazon is a direct competitor in the hosting & cloud business. In general, I've observed that investors are willing to pay and circle around a company's estimated next year's EPS times the earnings' projected growth rate. In the case of RAX, this would be $0.81 FY2012 EPS x 53 (52.83%) = $42.93. The stock as of this writing is $49.62.

See, when it comes to valuing a high growth company using the Discounted Cash Flow Analysis, slight variations in the components of the financial model causes sharp changes in your "target price." Whether you change the aggressive growth rate in the next 5 years, the market premium, or the terminal growth rate, will invariably result in a wild range of share prices. Since no investor can ever accurately forecast and predict the future (heck, analysts can't even accurately predict results for one year), then why bother trying to find a "true value"?

Once a company begins to be valued at 40x forward PE, or 50x, or 80x, or (gasp!) even 120x, the price starts to become irrelevant (if it's already crazy, what gives if it becomes even crazier). As long as the company continues to deliver, there will be investors willing to pay for it no matter how high the PE is. Sometimes investors think of a stock trading at 50x forward P/E as already too expensive. But the exact same argument would be said if the stock moves to 60x, 70x, or 120x.

When does it stop? Usually when there's a crack in the fundamentals (think Netflix (NASDAQ:NFLX)). Investors would have argued that it was irresponsible for anyone to recommend buying the stock of Chipotle Mexican Grill back when the price was at $180 because it was way overvalued. The same was said later on at $250. It was a complete sin at $300. Forget about $350. Truly unspeakable of now that it's at $375. You are going to continue on this path until who knows when.

The thing to remember here is that you're always and constantly analyzing the business model. As long as the company delivers due to an outstanding operating efficiency, things will probably continue to move upward (whether RAX's business model is truly outstanding and has a bright future remains to be seen, but so far they've executed).

But then it's at times like this that I remind myself of the wise words from Barry Ritholtz:

"I am rather frequently -- and on occasion, quite spectacularly -- wrong. But I expect to be. No one really knows what is going to happen in the future, so why pretend otherwise? When you anticipate being wrong, it makes it that much easier to both plan ahead and manage risk."

Those words are ingrained like a tattoo in the gray matter of my brain (is it really gray?). Think of the following for a minute. When you buy a stock, you're fully aware (or at least you should be) that you will never be able to buy at the very bottom. To think otherwise would be overly arrogant on your part. Knowing this fact keeps you humble and allows you to understand and accept your future predicting limitations, and pursue a more disciplined strategy to buy into a stock. One where you cost average as long as you continue to believe in the prospects of the business model .

For example, you know already that when you buy a "value" stock there's a big chance that the stock will continue to fall, yet you are mentally prepared to stomach the drop and buy again at a lower price as to bring your average cost down. The more it falls, the "cheaper" you think you are getting it for, and the lower your average cost. You are convinced that Mr. Market will eventually recognize the stock's "true value" and reward you handsomely.

Something very similar should take place on the other end of the spectrum. Yet there are plenty of people out there that no matter how great a company is they will simply refuse to pay a high price for it. This is not only irrational, but predictably so, and it's all explained by the psychological aspects of price relativity and risk aversion. But when you buy a "growth" stock, you should not enter into a full position in one single swoop, but rather you scale in.

How many times have you faced a situation where you have done your due diligence on a company. You know very well how the business operates and the strengths it has. You already analyzed the risks the company faces in the short- and long-term. You are fully convinced that the company will continue to deliver more often than not the growth and numbers required to push the stock higher. All you are doing is waiting for an opportunity to enter into the stock, only to see that the opportunity never materializes and the stock just keeps running away from you.

The point is, you need to find a way to manage risk and invest in a company whose share price appears extremely overvalued, benefit somehow from its continued riches yet avoid overpaying too much for it. First, you will need to decide how much of your portfolio you're willing to allocate into the stock, and then pursue a disciplined allocation strategy that you will follow through thick and thin (remember, this is as long as you continue to believe in the prospects and strengths of the business model).

Let's say you decide for a 5% allocation in a 100k portfolio. You don't want to invest the full amount ($5,000) in one single swoop, but rather in phases. Instead of waiting endlessly to invest in this company just to see the stock run away, you make an initial commitment of $625 at this point. If the stock drops in value from $50 down to $40 (20% drop) as a result of a bump on the road in one quarterly announcement or some sort of bad one-time event but you still believe in the business, you double down by committing an additional $625 of capital as to bring your average cost down to $44.29 (the calculations are provided in a table below). If it drops to $30 as a result of some nasty market correction, you double-down again by allocating $1,250 more for a $35.71 average cost. That's already $2,500 of capital deployed in the stock.

If the Gods of Fortune smile at you and the stock drops further to $20 or more (a 60% drop from its original value), you will commit the latest amount of $2,500 and bring your average cost down to $25.64. If you'd have allocated your entire amount at the initial price of $50, you'd be down 60% and you would need a 150% appreciation just to recoup your loses. The compounding effect of a price drop in a richly valued company is dramatic, and as such you have to protect yourself.

On the other hand, had you cost averaged your entry into the stock, you are now looking at a full investment of $5,000 at an average price of $25.64. You would need a 28.2% rebound just to break even. Although this is still high, it's quite a different picture under each scenario. At every point of course, you will need to take a step back and reassess the overall situation. It might be a lot wiser to call it a day and stop your loses. Never marry a stock if you realize the fundamentals have changed. Simply cut it out and move on. The beauty of the markets is that you will always find the next opportunity to "marry".

Share Price

Capital Available

Shares Bought

Actual Capital Deployed

Excess

Avg Cost

% to Break-Even

$50

625.00

12

600.00

25.00

50.00

0.0%

$40

650.00

16

640.00

10.00

44.29

10.7%

$30

1260.00

42

1260.00

0.00

35.71

19.0%

$20

2500.00

125

2500.00

0.00

25.64

28.2%

Total

195

5000.00

25.64

Think about this again. You are inherently following the exact same strategy as you would when investing in a "value" company. One whose stock continues to be punished by the market but you continue to believe in its turnaround. You don't know how far down the stock will go, but you lick your fingers thinking that the more it falls, the "cheaper" your average cost price. You would think that the risk/reward ratio is better investing in a cheap company than in a richly valued company. But quite the contrary. Great businesses are richly valued for a reason, and more often than not they will continue to deliver outstanding results (provided the fundamentals of the company, the sector, the competitors and the overall outlook of the markets do not change materially).

It might be the case that when you invest your initial $625, or maybe $1,250, the stock begins to rise never to look back again. At this point, it's up to you to deploy further capital at higher prices, but at least you're getting some benefit out of it, even if you invested at an already high price. This is the ultimate point of the strategy when it comes to investing in growth companies.

An additional problem with high growth stocks is that you really never know when to sell. The truth of the matter is that investors are never happy when it comes to selling any stock. If you sell your shares and the stock continues to appreciate, you are going to feel bad because you sold "too early". On the other hand, if you don't sell your shares and the stock drops in value, you are going to feel bad because you didn't sell prior to the drop. To resolve this dilemma an investor should follow the same strategy in selling (scaling out) as in buying (scaling in) the stock.

Unless you want to keep it for the really long-term (10-20 years if you're true to the principle), you should take some profits and reward yourself. There will be many other opportunities to deploy your capital elsewhere. I would suggest my friend to take some profits off the table. As Baron Rothschild once said "I made my fortune by selling too early". There's absolutely nothing wrong with taking some profits now. The difference between one "feel bad" (selling too early) and the other (not selling before the stock drops) is that in one you at least secure the profits. You can then proceed to feel bad if you want, but only after pocketing some of the gains.

In this article I'm not predicting the future of RAX. I'm simply stating the obvious fact that very high expectations are already priced in this company and the risk/reward ratio is unbalanced leaning towards the downside, no matter how great the business is. But if you must invest in it or any other "growth" company, try to keep the process simple and help yourself manage the risk more properly. Overcomplicating matters in the financial markets is a perfect recipe for bad returns, and one of the worst enemies of the average investor. Although I generally look for "value" companies, this strategy has worked very well for me whenever I use it.

It's also one strategy out of many. Certainly not new and certainly not a fit-for-all. Premiums in RAX's options are high because the stock is very volatile, and if possible I would even try to sell some covered calls, but that is beyond the point of this article. I humbly advocate the aforementioned strategy just for its simplicity, the advantages it provides and the managed risk.

It's so simple that investors forget to use it because greed, instant gratification and frequent trading is the bread & butter in today's markets. But stay disciplined. The core of the whole strategy relies on discipline. As long as you stick to your initial plan, the fundamentals don't change, and occasionally you take profits off the table you will be well off. Slow and steady wins the race.

As always, please remember that nothing in this world is certain but death & taxes (unless of course you are Nicolas Cage, or better said, his financial manager, or both).

Disclaimer: This article is intended to be informative and should not be construed as personalized advice, as it does not take into account your specific situation or objectives.

Source: Rackspace: A Cloud Up High In The Sky